Identifying risk in CUSOs

Over the last few years, NCUA put the spotlight on CUSOs by introducing a new CUSO regulation and highlighting some CUSO failures during the credit crisis.  The Chairman has been outspoken claiming CUSOs are creating systemic risk to the credit union industry.  The commentary to the new CUSO rule, issued at the November NCUA Board meeting and effective on June 30, 2014, states that CUSOs have contributed to the failure of several credit unions in recent years.  According to the NCUA Board, such losses result from loss of investment funds (equity and debt) and from losses incurred from the product or service offered by a CUSO.

How do these risks manifest on the credit unions books and create potential risks to the share insurance fund?  They are completely different types of risks that should not be conflated, and only one is truly a risk attributable to CUSOs.  On the one hand, credit unions should always identify the risks associated with a product or service whether a CUSO is involved or not.  On the other hand, investment risk is subject to the management and controls set out in the CUSO.

Product or service risks can run the gamut from reputation risk to compliance risk to credit risk and should already be accounted for at the credit union.  There is no greater risk to using products or services through a CUSO then through a third party vendor or another credit union.  Therefore, these risks are not inherently CUSO risks; instead they are the risks of doing business and providing good well rounded service to credit union members.  If anything, using CUSOs can drive down the cost of some of these risks by spreading them collaboratively among several credit unions instead of just one.

Most of the examples of losses given in the commentary to the new CUSO rule resulted from lending losses.  It is hard to determine how lending losses relate directly to CUSOs.  Credit unions that portfolio loans originated from any source must make a sound lending decision.  Furthermore, these loans would be audited through a normal NCUA examination.  Any loans held by a CUSO would not be a direct risk to the credit union except for potential investment losses.

Investment losses are the only unique CUSO risk.  Again, the nature of this CUSO risk has not changed over the last thirty years.  However, because CUSOs and collaboration are so important to credit unions and the survival of the industry, the magnitude of the overall industry risk may have increased over the years.  Even so, current industry numbers place the overall investment risk for the credit union industry at 22 basis points of the overall assets.

It is unclear how investment risk could create such risk to the credit union industry and require an enormous budget outlay from the NCUA to control such risk.  The old CUSO rule had limitations developed to put broad controls in place to limit investment risk.  We can presume the NCUA believes these limitations are not too broad because the new rule does not change them.  Credit unions are still limited to the same investment amount limitations (1% aggregate investment and 1% aggregate debt.)  These controls are in place to limit the risk of investment and to limit the potential for significant losses to the share insurance fund.  Furthermore, the new rule does not change the requirement for credit unions to obtain an attorney opinion letter stating that the CUSO is a separate entity.

The question becomes why there is a new CUSO rule.  The new rule has not changed the investment limitations.  Nothing has changed regarding the manner in which credit unions should address risks associated with the use of third party products and services.  The new CUSO rule boils down to requiring CUSOs to directly report to NCUA extensive information about their business model.  What does this direct reporting accomplish?  It could be to keep an eye on the investments of credit unions in CUSOs, but NCUA already has this ability through its examination of credit unions and the right to review the books and records of CUSOs as a part of the examination of credit unions.

I am not sure we will ever know why we are dealing with the new CUSO rule, but I find it hard to believe it is risk of loss.